Collateralized Fund Obligations Improve Investment Outcomes

Collateralized fund obligations can be a game-changer for investors looking to diversify their portfolios and improve investment outcomes.

By pooling multiple assets and issuing tranches with varying levels of risk, CDOs can provide a more stable income stream and potentially higher returns.

One key benefit of CDOs is their ability to isolate risk, allowing investors to choose from a range of tranches with different credit ratings and risk profiles.

This can be especially appealing to investors who want to balance their portfolios with a mix of low-risk and high-risk investments.

A CLO, or Collateralized Loan Obligation, is a portfolio of predominantly leveraged loans that's securitized and managed as a fund. This means it's a collection of loans that are packaged together to provide investors with a single investment vehicle.

CLOs originated in the late 1980s, similar to other types of securitizations, as a way for banks to package leveraged loans together to provide investors with an investment vehicle with varied degrees of risk and return.

Each CLO is structured as a series of tranches that are interest-paying bonds, along with a small portion of equity, which receives excess payments. This equity portion is the riskiest part of the CLO, as it's the last to receive payments in the event of an insolvency.

The assets in a CLO are typically senior secured loans, which benefit from priority of payment over other claimants in the event of an insolvency. This means that these loans are considered safer investments because they're secured by collateral.

The first vintage of modern CLOs, known as CLO 1.0, was issued starting in the mid- to late-1990s and included some high yield bonds, as well as loans.

CLOs can offer investors multiple benefits, both on their own and versus other fixed income sectors. They have strong returns, outperforming other corporate debt categories like leveraged loans, high yield bonds, and investment grade bonds over the long term.

CLOs have also outperformed on a risk-adjusted basis, generating higher Sharpe ratios than many other credit asset classes. This means they provide a better balance of return and risk for investors.

Some of the key benefits of CLOs include:

CLOs have historically presented lower levels of principal losses relative to corporate debt and other securitized products. For example, among CLOs rated by Moody’s, there have been zero defaults on the AAA and AA tranches across all vintages.

CLOs have consistently outperformed other corporate debt categories over the long term, including leveraged loans, high-yield bonds, and investment-grade bonds.

Strong returns are a hallmark of CLO tranches, with many outperforming at lower rating tiers. In fact, US CLO debt has outperformed investment-grade credit, high-yield bonds, and leveraged loans over the past decade.

CLOs have also generated higher Sharpe ratios than many other credit asset classes, making them an attractive option for investors seeking to optimize their fixed income portfolios.

A key advantage of CLOs is their low interest-rate sensitivity, as they are floating-rate instruments that move in tandem with benchmark rates.

Here are some key metrics that illustrate the attractive risk profile of CLOs:

These statistics demonstrate the relatively low risk of CLOs compared to other corporate debt and securitized products.

US CLOs have outperformed other corporate debt categories, including leveraged loans, high yield bonds, and investment grade bonds, over the long term. This is according to J.P. Morgan, Bloomberg, and LCD, as of 30 September 2024.

One key metric that highlights the outperformance of CLOs is the Sharpe ratio, which measures risk-adjusted returns. CLOs have generated higher Sharpe ratios than many other credit asset classes.

A higher Sharpe ratio indicates that an investment has delivered stronger returns while taking on less risk. This is a key advantage for investors looking to optimize their fixed income portfolios.

CLOs also offer attractive risk profiles, with lower levels of principal losses relative to corporate debt and other securitized products. In fact, among CLOs rated by Moody’s, there have been zero defaults on the AAA and AA tranches across all vintages (1.0 through 3.0).

Here's a comparison of default rates among CLOs and other corporate debt:

This data is based on CLOs issued from 1994-2009 and rated by S&P (vintage 1.0 CLOs).

CLOs have a unique ability to attract a diverse range of investors, offering benefits to various types of investors.

The CLO market has traditionally been dominated by institutional investors such as insurance companies and banks, which are drawn to the senior-most tranches of CLOs that offer high-quality capital and income.

However, the CLO market has recently opened up to retail investors through the emergence of ETFs, which have grown from approximately $2 billion at the start of 2023 to over $14 billion by the middle of 2024.

This diversification of the investor base has created opportunities for a wider range of investors to participate in the CLO market.

About two-thirds of CLO managers with post-crisis deals under management are based in the US, while the remaining third are based in Europe, highlighting the global nature of the CLO market.

The CLO market has also seen a significant increase in the number of investors, with approximately 225 CLO managers worldwide, as of the relevant article section.

Collateralized fund obligations (CFOs) and revolving note funds (RNFs) involve the issuance of debt instruments supported by limited partnership interests in a single master fund or portfolio of underlying funds.

Careful deal structuring and payment waterfalls enable the creation of different tranches of notes, each structured to meet specific investor needs. Senior tranches offer fixed returns expected by debt investors.

In a CFO or RNF structure, senior tranches are typically rated to reduce capital retention requirements for regulated investors, making them an attractive investment for insurance companies and sovereign wealth funds.

CFOs and RNFs involve the issuance of debt instruments, supported by limited partnership interests in either a single master fund or portfolio of underlying funds.

Securitisation technology allows sponsors to raise financing through a feeder fund or a bankruptcy remote special purpose vehicle (SPV), which invests the investor’s capital into the sponsor’s private equity or alternative strategy funds.

Careful deal structuring and the use of payment waterfalls enable the creation of different tranches of notes, each tranche structured to meet specific investor needs.

Senior tranches offer the fixed returns expected by debt investors, while subordinated or equity tranches can vary in line with gains or losses on the underlying investments.

Senior tranches in CFO and RNF structures are typically rated, reducing the capital retention requirements for regulated investors.

Here are the different stages of a CLO's lifecycle:

Leveraged loans are more than just collateral for CLOs; they're the fuel that powers CLOs' attractive income streams and the first level of potential risk mitigation built into the CLO structure.

They pay interest on a consistent monthly or quarterly basis, trade in a highly liquid secondary market, have a historically high recovery rate in the event of default, and originate from a large, diversified group of issuers.

When designing a structure, it's essential to consider the purpose and goals of the project.

A clear and concise scope statement can help ensure that all stakeholders are on the same page and working towards the same objectives.

The scope statement should include specific details about what is included and excluded from the project, as well as any relevant assumptions and dependencies.

In the example of the new office building, the scope statement included detailed information about the number of employees, workstations, and meeting rooms required.

A well-defined scope statement can help prevent scope creep and ensure that the project stays on track.

It's also crucial to consider the physical constraints of the project site, such as the available space and any zoning regulations.

In the example of the new office building, the project team had to work within a limited budget and ensure that the building design fit within the allocated space.

A thorough analysis of the project's physical constraints can help identify potential challenges and opportunities.

Regular communication with stakeholders is vital to ensure that everyone is informed and up-to-date on the project's progress.

In the example of the new office building, the project team held regular meetings with the client and other stakeholders to discuss the project's status and address any concerns.

Effective communication can help build trust and ensure that the project stays on track.

The Collateralized Fund Obligation (CLO) market has undergone significant changes in recent years. CLO vintages 2.0 and 3.0 represent nearly all of the market today.

These newer vintages have become the norm due to their improved structure and increased investor demand. As of 30 September 2024, this is according to Bank of America Global Research.

Private equity firms are struggling to raise funds, with at least two US state pension plans considering setting up CFOs to free up cash.

Raising funds is getting tougher, so private equity firms are turning to more complicated types of CFOs as a possible solution.

A type of CFO called a "collateralised continuation fund obligation" or CCFO is being considered, where an investor sells its fund stake to a new vehicle managed by the private equity firm.

In this model, the investor receives some cash and a share of the equity in the CCFO, which issues bonds to bring in fresh cash for the private equity firm's new funds.

US CLOs can enhance Sharpe ratios and limit the downside, according to a Bank of America newsletter.

Clo vintages 2.0 and 3.0 dominate the market today, representing nearly all of it.

Bank of America Global Research confirms that as of 30 September 2024, these two vintages account for a significant share of the market.

According to the latest data, Clo vintages 2.0 and 3.0 have become the standard in the industry.

This shift in market dominance is a clear indication that these vintages have gained widespread acceptance and adoption.

The dominance of Clo vintages 2.0 and 3.0 is a testament to their quality and reliability, making them the go-to choice for many consumers and businesses alike.